One of the main questions for the US economy in 2023 is how the trajectory of inflation will unfold. While the Federal Reserve's forecast for core inflation this year is 3.5%, the view of markets is that it will come in somewhat lower than that, particularly after Thursday’s Consumer Price Inflation report. But the evolution of the ”core goods” and housing-related parts of inflation, which account for roughly 70% of core inflation overall, suggest that even the markets have a forecast that's too high.
On the surface this is great news — who wouldn't want inflation to be lower than expected? But there are significant caveats here. Rather than settling at a low level, inflation is going to bottom out at an unsustainably low point — perhaps as low as 1% — before bouncing back, possibly to a level above 3% that's still "too hot." This is going to pose a challenge to both investors and the Federal Reserve.
The easiest way to lay this out is to look at what's happened with used vehicle prices since the onset of the pandemic. Prices rose by more than 50% between the middle of 2020 and the beginning of 2022. Since then, they've fallen by 10%. Even though prices are still almost 40% above mid-2020 levels, because we calculate inflation on a year-over-year basis, used vehicle prices are now detracting from measures of inflation.
This dynamic — prices still up a lot from 2020 but decelerating or negative on a year-over-year basis as supply chains and levels of demand normalize — is playing out throughout the economy. That will temporarily pull measures of inflation down to perhaps historically low levels.
Core goods — a category of products which accounts for 27% of core CPI that includes automobiles, furniture and apparel — fell at almost a 5% annualized rate in the fourth quarter of 2022. We should expect even more declines for at least part of 2023 as the new vehicle market gets back into balance (Tesla Inc. slashed pricing on new vehicles Friday), and as lower freight and other costs flow through to benefit retailers. The weakness in core goods inflation in the fourth quarter is the main reason that core CPI, stripping out housing, has been negative for three consecutive months.
Adding to that, I just wrote last week about how weak the rental market became in the second half of 2022, particularly the fourth quarter. Because of the way it’s measured in the CPI report, this weakness won't show up in the housing-related portions of inflation until the second half of 2023. Shelter represents 42% of core CPI and the last time we had weakness in both home prices and the rental market, the shelter portion of CPI was negative in 2010, so we could see the same thing happening later this year.
If core goods inflation turns negative on a year-over-year basis and stays there for a while — which will likely happen in the second quarter of 2023 — and that coincides with some temporary weakness in measures of shelter inflation, there's almost no mathematical way that overall core inflation can exceed 2%. To show this in practice: If core goods inflation is -2%, shelter inflation is 0%, and everything else is 5%, you get to an overall level of core inflation of 1.0%.
So there's a pretty good chance we're going to be talking about inflation below 2% by the end of this year, but this would be an extremely temporary phenomenon. Core goods prices would merely have to stay flat for their negative contribution to go away over time. The recovery in home prices and rents in the early 2010s led the shelter portion of inflation to bounce back by 2012.
Needless to say, this roller coaster is going to make it difficult to peg the trend for inflation, particularly if the labor market remains resilient as expected. We'll get a better handle this year on how much inflation was due to swings related to the pandemic, and until then we should lean more into levels of income growth or nominal gross domestic product growth as proxies for underlying inflation. When personal incomes were growing at a pace of about 5% in the 2010's, that was consistent with a rate of inflation within the Fed's comfort zone. Perhaps income growth above 6% will be where things are viewed as running too hot, while anything in between 5% and 6% will be a bit uncomfortable but largely acceptable to policymakers.
If it transpires as I expect, a low unemployment rate combined with temporarily low inflation and solid economic growth would amount to some well-deserved egg on the faces of economists who spoke too confidently in mid-2022 about the recession we'd need to rein in labor markets and inflation. The ripples from post-pandemic normalization continue to play out, and it's only fair if everyone gets a little bit humbled by them.
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